Babcock starts to turn the ship around

Things are looking brighter for defence contractor Babcock (BAB) than they were a year ago, when a reassessment of contract profitability and carrying values on its balance sheet led to it incurring an impairment charge of £1.3bn, contributing to a pre-tax loss of £1.8bn.

Chief executive David Lockwood set about repairing its fragile balance sheet, pledging to raise £400mn from asset disposals. 

It has exceeded this, raising £447mn from four sales – Frazer Nash Consultancy for £291mn, the power business for £50mn, an oil and gas arm for £10mn and its 15.4 per cent share of plane-to-plane refuelling business Air Tanker Holdings for £96mn.

The sales have helped to bring its covenant net debt (excluding leases) down by over £200mn to £617mn, or 1.8x cash profit – below a target it had set of 2x.

The reduction gives it some leeway to fix other things – gearing could temporarily rise again to over 2x cash profit to allow it to make catch-up payments of £100mn on its pension deficit and to pay back a further £45mn of debts owed to suppliers. 

Lockwood said the turnaround had made progress “despite geopolitical volatility and a challenging economic environment”. 

That volatility has also been a blessing, though – allowing it to win more work as governments allocate more money to defence spending. 

Its contract backlog has grown by £1.7bn to £9.9bn as it secured several big wins, including a £3.5bn five-year contract to provide engineering support to the Royal Navy and a €500mn (£418mn), 11-year deal to provide training to French air defence customers.

It’s also managed to do this profitably, growing its underlying operating margin by 30 basis points to 5.8 per cent. 

In past articles, we’ve said we’d find it difficult to change our sell recommendation until a clearer picture emerged of Babcock's long term future. The work it has done so far, and the improved outlook for the defence industry, has given it a much better chance of securing that.

It is by no means guaranteed, though, which is why the company’s share price rebound of 7 per cent so far this year has lagged peers. Around half of its total borrowings are short-term, including a €550mn bond due in October. The asset sales mean it has the cash to pay this off in full if it sees fit but they also mean its growth prospects are more limited. Move to hold.